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A Match Can Cause a Forest Fire: A Response to Brad DeLong

My essay on causes of the financial mess focused on trying to identify the initial “impulses” that set the boom-bust cycle in motion because (as this symposium shows) economists have a variety of views about the impulses, and because identifying them correctly is our best hope for avoiding policy mistakes going forward. Nonetheless I agree with Brad DeLong that the question of the “propagation mechanisms” is also vitally important. We do face major puzzles in understanding the mechanisms that have turned monetary policy swings of merely large size (combined with regulatory distortions) into a financial mess of freakishly large size.

In his list of five factors accounting for the decline in the value of global financial wealth, Professor DeLong says little to emphasize the cluster of malinvestments, the rafts of investment projects — particularly in real estate — that have turned out to be wealth-squandering mistakes, leading to the writing down of financial claims that funded them. I guess they fall under his third heading, “default discount” (although they might go under “savings and investment” with a negative sign). Clearly, overbuilding has driven the declines in real estate and mortgage markets. We have a glut of housing overhanging the market. I was offering an account of how that arose.

I am perplexed that Professor DeLong calls the market’s rate of time-discount (his fourth factor) a “liquidity discount” or “liquidity premium.” Such a label invites confusion between the premium placed on present-datedness (the height of the real interest rate) and the premium placed on a security’s ready saleability (as indicated by a narrow bid-ask spread). The time-discount rate is applied based on temporal distance (what Brad calls “the date at which the cash will arrive”), and its determination was famously analyzed by Irving Fisher in The Theory of Interest. Discounting the future more heavily, as he rightly notes, is not a reason for lower asset values these days: real interest rates are low. Heavier discrimination against illiquid securities might be at work, but is not on his list of five factors.

I agree that “the ability of central banks to swing the [real interest rate] as they have in the past year and a half is a mystery.” But if we recognize that ability as a fact, we recognize that the Fed could have a potent effect in creating the low real rates in 2002-2006. (It was not only due to a global savings glut, as Alan Greenspan has maintained.) It is not a mystery how a major drop in real interest rates, if projected to continue, can strongly boost prices of long-lived assets like land: simply apply the present value formula for a perpetuity. It is therefore not a mystery how huge amounts of paper wealth can be destroyed when the interest rate rises back to equilibrium. No doubt lower credit standards and other factors played important roles in exaggerating paper wealth gains and reversals. But Professor DeLong’s suggestion that monetary policy swings measured by the size of change in the monetary base cannot have led to much larger swings in nominal wealth simply because “the magnitudes just do not match” is, to use Roger Garrison’s analogy, like saying that a tiny match cannot have caused a forest fire.

Professor DeLong ends up blaming the lion’s share of the decline in financial wealth on a change in tastes: “$17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago.” I wonder whether he could say more about how we can distinguish such reduced tastes for given risks from upward revisions in estimates of the sizes of asset risks and their interrelations. (Many financial firms have of course found that their risk assessment models needed major re-calibrations.) I agree with him that we don’t have a good theory of changes in risk-aversion tastes. Nor do we have policy remedies for changes in tastes or in risk assessments. Efficiency in the face of changing tastes ordinarily calls for letting relative prices and quantities adjust to the new tastes.

A minor correction to what I suppose is a typographical error: the Bank of England first adopted a lender of last resort policy in the 1890s, in response to the Baring Crisis, not in the 1830s.

Turning from monetary policy to regulatory policy, Professor DeLong says that the Community Reinvestment Act is a “red herring” because it “has been around in more-or-less its current form for a generation.” My actual argument, however, was that there was an importantchange in its form: legislation and regulatory enforcement that gave the CRA teeth for the first time in the mid-1990s. It may still be the case that the magnitude of direct CRA effects was small, as Randy Kroszner has recently argued in reporting that the CRA-linked share of subprime lending was only about 8%.

I’m not persuaded by the fact that Bear Stearns failed slightly ahead of Fannie Mae and Freddie Mac that Fannie and Freddie and HUD didn’t contribute to the problem of lowered credit standards.

Professor DeLong proposes that we are better off pursing psychological explanations for poor contract design — though he admirably acknowledges that these “seem to involve, at the moment, a great deal of handwaving” — than pursuing the hypothesis “that our current financial crisis is the result of our abandonment of a proper gold standard and our embrace of fractional-reserve banking and government-sponsored mortgage lending enterprises.” But the second hypothesis is not mine. We abandoned the gold standard many crises ago, so that can’t explain the timing of this one. And Professor DeLong has me confused with someone else if he thinks I blame fractional-reserve banking. Freedom of contract implies the freedom to make fractional-reserve contracts, as well as other innovative financial contracts, and to take risky financial positions. Financial innovation and risk-taking are, in the long run, good things for economic growth, provided that the system weeds out innovative but poorly designed contracts. To let it do so we must hold parties to their own contractual commitments to the point of bankruptcy, and let them take their lumps when their counterparties default, rather than bail anyone out.

The turmoil under our current regime can only strengthen, I would think, the probability we assign to the hypothesis that our fiat money regime and legally restricted financial system is less robust and less efficient than the alternative of a laissez-faire commodity-based monetary and financial system. But comparative regime analysis is a topic for another day. My diagnosis of the impulses for the current turmoil supports more immediate policy reforms under our existing regime, namely that the Fed would do better pursuing stable (preferably zero) growth in nominal income, and that, yes, we should end our embrace of government-sponsored mortgage lending enterprises and other housing market distortions.

Also from This Issue

In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages – even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud – and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests – especially about the aggregate wealth effects of the boom and bust – would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story – focusing on the money supply and government policy to encourage bad home loans – cannot be the right one.

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